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Indexed Annuities Explained

Annuities are contracts that are purchased by investors from insurance companies in exchange for promise of future payment. There are several annuities which exist, including variable, fixed, and indexed annuities. Like other annuities, indexed annuities can provide several key benefits to investors including a way to defer taxes and increase the amount of their initial investments.

Index annuities offer features that are unlike other annuities offered as they are specifically linked to the performance of the market as a whole. Since the rate of return for the investor relies on the performance of the index market, it is possible for the investor to ultimately get less in return than what he actually paid into the annuity – again, depending on the terms of the contract and the market. However, if the market performs above average, the investor also gets to realize that growth year after year without having to pay any taxes on that growth until he makes his first withdrawal on the account.

As with other annuities, this can provide an excellent way to increase future retirement income and defer any taxes. As always, an investor should review the contract features of the indexed annuity they purchase, as these investments may or may not be registered with the SEC. Generally, for SEC registered indexed annuities, the investment must provide a minimum rate guarantee of return for the investor. Due to the inherit nature of this time of annuity and the typical market fluctuations, this is not always guaranteed. Nevertheless, index annuities provide a certain option for those wanting to invest and diversify their portfolio to an instrument that is linked directly to the performance of the market.

Since annuities are not guaranteed by the FDIC, as other bank accounts are, investors who purchase annuities should be aware of the inherent risks due to the volatility of the market. Due to the fact that index annuities may particularly sensitive to the market’s performance, an assessment of risk should also be made on the stability and solvency of the issuing insurance company.

As with other savings vehicles, the investor should know several key features to the index annuity before entering the contract with an insurance company, such as the rater of return, and margin fees (sometimes referred as administrative fees).  These fees can take a take a chuck of the annuity growth during the distribution phase.  An investor would be wise to ask either his insurance agent what those margin fees would be. For a typical indexed annuity contract, the margin fee might be 2% or 3%. This fee is justified by the insurance agent as an “administrative” fee to maintain the account. Nevertheless, it could chip away at the investor’s earnings.

With index annuities, there may also be ceilings or the maximum rate of interest imposed in the contract which can be earned by the investor. These ceilings could significantly reduce potential earnings for the investor. Take for example the interest rate ceiling for an index annuity contract is set at 10%. In addition, let us assume that the market grows 15% over a lifetime of the annuity for 25 years. According to the contract ceiling, the investor would only be entitled to the 10% minus the 2% margin fee. In the end, he may only be entitled to 8%. It is therefore in the investor’s interest to ask about all fees with any annuity he or she purchases – including the administrative fees.